Professional Insurance Programs

Where will the money come from?

How would a death or disability affect your business? When these events occur, your practice could be significantly impaired or forced to close in a short period of time, not because you did something wrong, but because you did nothing.

A properly funded buy-sell agreement can help solve this problem. This agreement is a contract between different entities (partners) within a corporation to buy out the interests of a partner who is deceased or becomes disabled. This agreement allows the surviving partner(s) to keep continuity of ownership and management and the decedent’s estate to turn a non-liquid asset they likely have little interest in into cash to take care of the financial needs of the family. It can also help protect the practice from loss of revenue and cover the expenses required to find and train a replacement.

Owners, may recognize the need for such an agreement, but are hesitant to spend the money needed on life and disability premiums to fund it. They tend to think that paying the buy-out over a set amount of years, on an installment basis is the best solution. They’re usually wrong.  This line of thinking is typically created by the failure to grasp how much of the cash flow will be exhausted by the surviving partner(s) to cover that installment agreement. It’s highly unlikely they and/or the business will have the cash readily available to pay a lump sum to the deceased partner’s estate or disabled partner themselves. This is also true of the cash flow to cover the installments, especially when the repayment term is long.

Example: Dr. Smith and Dr. Jones are 50/50 owners of a practice valued at $2,000,000. The practice has a buy-sell that requires the surviving partner to purchase the deceased partners interest for $1,000,000 using an installment agreement that’s payable over 10 years at 8% interest. Since neither surviving owner would have the $1,000,000 in cash to pay the lump sum they’ll have to generate enough business profit to meet the installment requirement. The practice has a 10% profit margin.

Let’s assume, for simplicity that the annual installment agreement is $150k/year for 10 years. The payment obligation is not deductible, which means the surviving partner has to earn $250k/year in income to net $150k (assuming a 40% marginal federal and state tax bracket). In order to earn that $250k the surviving partner has to general annual sales of $2,500,000 or $25,000,000 over the 10 year period.

Consider the following questions:

  • Could the surviving partner generate enough profit to meet the installment agreement without sacrificing a chunk of their own income for personal needs?
  • How will the death of one partner impact production? How will this be made up?
  • Will the company have to hire someone to take over the responsibilities of the deceased or disabled partner? Where will this cash flow come from and how much is even needed?
  • How will this installment agreement impact the ability of the Company to pay salaries, fulfill other business obligations or expand the business itself?
  • What about the existing company debt when a partner is deceased or steps away from the business due to disability?

The answer to all these questions can be found in a buy-sell agreement properly funded by a life and disability insurance policy that will pay out a TAX FREE lump sum at the exact time it’s needed. Professional Insurance Programs can help develop an agreement to ensure a smooth transition that fits with your vision for the future of your business.